Update 678 — Inflation vs. Banking Crisis:
Fed Announces 25 bp Interest Rate Hike
Fed chair Jerome Powell is earning his salary this week, leading the Fed to a decision today unlike one he and the Fed have ever faced. It was only two weeks ago that Powell floated a 50 bp interest hike, testifying in response to a question from Sen. Elizabeth Warren about the millions of job losses that would result from interest rate hikes: “Will working people be better off if we just walk away from our jobs and inflation remains 5, 6 percent?”
Then came the collapses of SVB, Signature Bank, and a banking sector effort to rescue the First Republic. Making fewer headlines, but central to the Fed’s decision was a CPI report for February, showing prices stubbornly elevated but perceptibly easing. Against this backdrop, the Fed may have decided that ending its program of consecutive rate increases would itself signal systemic risk concerns at a time when “the situation is stabilizing,” per Treasury Secretary Yellen yesterday. How did the Fed decide? Details below.
This afternoon, the Federal Reserve raised the Target Federal Funds Rate for the ninth consecutive time, continuing its most aggressive series of rate hikes since the early 1980s. The 25 basis point hike, of 4.75 to 5.0 percent, comes amid heightened anxiety about the stability of the U.S. banking sector following recent bank collapses and federal intervention. It remains to be seen whether the Fed’s attempt to both tame inflation and soothe markets will achieve either objective, much less broaden the possibility of a soft landing this year.
Source: Federal Reserve, Graphic compiled by the New York Times
On March 8, when Silicon Valley Bank announced its $21 billion sale of U.S. treasuries and mortgage-backed securities – and the resulting loss of roughly $1.8 billion – it triggered a series of events that drastically shifted the landscape within which the Federal Open Market Committee decides its monetary policy.
Earlier that very week, Federal Reserve Chairman Jerome Powell testified before the House Financial Services Committee and Senate Banking Committee on the Fed’s Semi-Annual Monetary Policy Report. His comments indicated an increase “higher than previously anticipated,” suggesting a possible rate hike of 50 basis points rather than the 25 basis point increase that was widely expected before his testimony.
Meanwhile, releases of the latest data show that the job market has remained resilient. February’s jobs report showed another larger-than-expected addition of jobs to the American economy, about 311,000 jobs as measured by the Payroll Survey and 177,000 jobs measured by the Household survey. The unemployment rate ticked up slightly to 3.6 percent and the labor force participation rate remained little changed at 62.5 percent. Wages grew by 4.7 percent over the past 12 months, but just about 3 percent annualized in the last two to three months. While the 12-month figure may not have eased the Fed’s concerns about job growth remaining higher than they would prefer, the most recent data on wages would tend to ease their concerns.
Additionally, the most recent data on inflation was in line with expectations and would have failed to, on its own, shift the Fed’s trajectory on rate hikes following Powell’s testimony. The February CPI report showed inflation clocking in at 6.0 percent year-over-year and 0.4 percent month-over-month, marking the smallest year-over-year increase since September 2021.
Market Doing the Fed’s Work
While the Fed’s recent decisions on interest rate hikes have been focused on assessments of economic data and geared at cooling inflation, maintaining the stability of the U.S. banking sector was front-of-mind at this week’s FOMC meeting. Fed watchers had speculated as to whether the central bank would pause hikes and then reassess at its next meeting in May.
The Fed’s interest rate hikes led to a substantial fall in the value of Silicon Valley Bank’s hold-to-maturity investments ahead of the run on SVB and the bank’s eventual collapse. The Fed is mindful that SVB was by no means the only depository institution to acquire longer-term maturity assets while interest rates were low. Earlier this month, FDIC Chairman Martin Gruenberg stated that most banks have some amount of unrealized losses on securities, with total unrealized losses held by banks totaling about $620 billion at the end of 2022.
A paper by researchers at the National Bureau of Economic Research, among others, found that the market value of assets in the U.S. banking system is $2 trillion lower than that suggested by the book value of assets when accounting for loan portfolios held to maturity. It also found that 10 percent of banks have larger unrecognized loans than SVB did, while ten banks were less capitalized. While many of these banks will hold their investments to maturity and never have to realize mark-to-market losses, the study underscores the fragility of the system that could be intensified by higher interest rates.
The consequent tightening of credit conditions in the banking sector may have pushed the Fed to reject a larger-scale interest rate hike than we saw today. Ironically, these conditions themselves serve to do what Powell acknowledged in his post-announcement press conference, saying that the crisis’ effect “is the same as our monetary policy.” Analysts have estimated that to this point, the credit squeeze has been equivalent to what a 25 or even 50-bp rate hike would do.
Anxiety Remains in the Banking Sector
Over the course of this week, developments have continued within the banking sector both domestically and internationally. Safeguards announced by central banks and regulators have proven to be insufficient stopgaps. The Fed and FDIC moved swiftly in response to the crisis with a number of interventions:
Domestic Bank Receiverships and Depositor Protections
- First Republic Bank – Last week, 11 of the nation’s largest banks announced that they would inject a total of $30 billion into First Republic Bank. Despite this, the bank’s stock price has fallen 87 percent within the last two weeks and has seen roughly $70 billion in the outflow of deposits since the collapse of SVB. Yesterday, First Republic continued to seek a capital infusion and considered a downsize.
- Signature Bank – Following the bank’s failure last week, the FDIC announced that New York Community Bank would purchase a portion of Signature which would then be incorporated into their subsidiary, Flagstar Bank.
Citing systemic risk circumstances, the FDIC announced that all depositors would be protected in these cases. Moreover, when asked at his press conference if depositors at a small, non-systemic bank were all protected, Powell said yes.
New Fed 13(3) Credit Facility
- Bank Term Funding Program – The Fed announced its new Bank Term Funding Program (BTFP) on Sunday, which will provide a safeguard against additional bank failures by providing liquidity against high-quality securities and eliminating institutions’ need to quickly sell those securities in times of stress. The BTFP would provide loans for up to one year for banks, savings associations, credit unions, and other eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. An up to $25 billion backstop for the BTFP provided by the Treasury Department through the Exchange Stabilization Fund should provide additional space to banks seeking liquidity without taking similar losses.
- Credit Suisse –Despite Switzerland’s central bank stepping in to provide a 100-billion franc backstop for Credit Suisse last week, UBS announced its purchase of the bank on Monday.
- Dollar Liquidity Swap Line – To provide broader stability to the international financial system, this weekend, the Fed, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank joined in a coordinated action to enhance the provision of liquidity through the standing U.S. dollar swap line arrangements. The central banks currently offering U.S. dollar operations agreed to increase the frequency of 7-day maturity operations from weekly to daily through the end of April.
A Soft Landing?
The Fed may have sought to moderate its previously suggested 50 basis point hike while being cautious of appearing overly reactive to uncertainty in the banking sector. The possibility that the Fed’s monetary policy decisions will tip the economy into recession persist, and all eyes will continue to be on the central bank as it navigates bolstering confidence in the global and U.S. financial system while still seeking to cool inflation. Over the weeks until the next FOMC meeting in May, the Fed will have to focus on building confidence in regional banks as their shares continue to fall and prepare to reassess its monetary policy direction.
In the meantime, Congress and Fed Vice Chair of Supervision Michael Barr will review the circumstances surrounding the collapse of SVB. Early indications are that policymakers both on the Hill and within the regulatory community are looking to increase the deposit insurance limits to cover non-consumer deposits over the current $250,000 threshold. Despite concerns about moral hazard, there is significant interest in pursuing this approach as an additional tool to address the current concerns on mid-sized bank stability.